CHINA’S CHALLENGEAs low-end manufacturing jobs leave, what will take their place?

China is trying to climb the technology ladder but has developed only a handful of globally competitive manufacturing companies. As labor-intensive jobs leave China, Chinese managers are responding to soaring labor costs at home by automating their factories and acquiring foreign companies with crucial management know-how.

When BYD burst onto the world stage in 2008 with battery- powered automobiles, Chairman Wang Chuanfu spoke boldly of finding a US distributor for his company’s cars. Warren Buffett, widely considered one of the world’s savviest investors, bought nearly 10% of the company’s shares for US$230 million.

When investors discovered BYD was assembling its lithium ion cells by trial and error and that it lacked the equipment to produce the cells in large volume at high quality, the bubble burst. Germany’s Daimler rushed in with the right gear, but BYD’s workers have not yet mastered the technology. Today, BYD sells only a handful of electric cars, all in its home town of Shenzhen, China.

BYD’s story is typical of the challenge facing most of China’s companies, state-owned and private. As wages climb, low-end, labor-intensive manufacturing activity is leaving China, but the nation has yet to demonstrate a mastery of more sophisticated manufacturing processes.

“We know we can’t keep relying on a low-cost competitive advantage,” Commerce Ministry spokesman Shen Danyang said in January. “We need to accelerate the value-added upgrading of our products.” Meanwhile, China’s Ministry of Industry and Information Technology set a goal of creating five to eight Chinese electronics companies with strong brand names and at least US$16 billion in sales by 2015.

If China cannot break out of its position as a low-end manufacturing workshop, the implications for its workers are stark: millions will be displaced, blocked from moving into higher-paying, higher-skilled positions. “Some companies will make the adjustment, but it’s not clear that China collectively is nimble enough to make the transition quickly enough,” said David Wolf, head of the Global China Practice at Allison & Partners in Beijing and a respected observer of Chinese companies.

USING CAPITAL, NOT CHEAP LABOR

The traditional wisdom of why Chinese companies won’t follow the lead of Japan’s Toyota Motors and South Korea’s Samsung Electronics up the technology ladder is familiar. First, China’s lack of intellectual property (IP) protection discourages innovation because ideas can so easily be stolen. Meanwhile, the Communist Party limits the free flow of information and has shifted massive resources to state-owned enterprises. Smaller private companies, though more innovative, lack access to capital. A few firms – Lenovo, Huawei, ZTE, Haier and Geely Automotive – have made global inroads, but most of their Chinese peers are preoccupied with their vast home market.

The two newest threads of the debate center on automation and foreign acquisitions.

“WE KNOW WE CAN’T KEEP RELYING ON A LOW-COST COMPETITIVE ADVANTAGE.”

SHEN DANYANGCHINA’S COMMERCE MINISTRY SPOKESMAN

Automation: Chinese factories are acquiring massive quantities of robots and software aimed at improving productivity. Hao Jianjun, the general manager of Great Wall Motors, recently told Business Week, for example, that he is spending US$161 million on mechanizing four auto plants with 1,200 robots. “Within three years, this cost will be completely paid for in savings from reduced worker wages,” Hao said. China’s overall purchases of robots quadrupled from 2006 to 2011. Similarly, the Chinese are buying software to allow their plants to better coordinate production.

Skeptics note that the Chinese will still lag in meeting global manufacturing standards, which are rapidly escalating. “The technologies that are going to recast manufacturing in the next decades are going to be robotics, artificial intelligence, three-dimensional (3D) printing and very powerful sensing devices that will allow for highly intelligent and flexible manufacturing floors,” said Abe Reichental, president and chief executive of 3D Systems in Rock Hill, South Carolina (USA). “The Chinese factories are set up to do very large volumes of one product.”

Foreign Acquisitions: Thanks to roughly US$3 trillion in foreign exchange reserves, Chinese firms have been buying up natural resource- and energy-related companies as well as technology companies. Recent purchases include A123 Systems, a US maker of lithium ion batteries, and Complete Genomics, a DNA sequencing company.

The classic acquisition remains Lenovo’s 2004 purchase of IBM’s personal computer division. Lenovo obtained both ThinkPad technology and the human resource, finance and marketing disciplines developed by a major US multinational.

$3 trillion

China has foreign exchange reserves equal to US$3 trillion, which it is using to purchase Western companies and their business know-how.

Oded Shenkar, professor of business at Ohio State University and author of Copycat: How Smart Companies Use Innovation to Gain Strategic Edge, argues such acquisitions will help the Chinese overcome their limitations. “You can’t extrapolate from Japan and South Korea,” Shenkar said. “China is going to use their advantage of cheap capital. They are going to buy out the innovators. It is a very different model.”

Acquiring knowledge will accelerate China’s growth curve, Shenkar said. “Ordinarily, it would have taken Lenovo decades to develop the capabilities they got out of buying the IBM division.” He noted that Geely Automotive is attempting to make a similar leap by buying Volvo from Ford Motor Co., giving it instant presence in Europe and the US, plus access to Western management know-how.

PATH AHEAD: UNCLEAR

Not everyone believes the acquisition strategy will work. “Acquisition is easy – integration is a monster,” Wolf said. He noted that Lenovo suffered internal management upheaval after purchasing IBM’s PC division, losing most of its international market share before staging a recent resurgence. “It’s not clear to me that other companies will have it any easier.” Still, the Chinese have repeatedly surprised Western skeptics. “They don’t have any truly global manufacturing companies today,” Shenkar said. “But are they capable of building them? Yes.”